What is the IS-LM Model
The IS-LM model, which stands for "investment-savings, liquidity-money," is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the loanable funds market (LM) or money market. It is represented as a graph in which the IS and LM curve intersect to show the short-run equilibrium between interest rates and output.
BREAKING DOWN IS-LM Model
British economist John Hicks first introduced the IS-LM model in 1937, just one year after fellow British economist John Maynard Keynes published "The General Theory of Employment, Interest, and Money." Hicks's model served as a formalized graphical representation of Keynes's theories, though it is used mainly as a heuristic device today.
The three critical exogenous – i.e. external – variables in the IS-LM model are liquidity, investment and consumption. According to the theory, liquidity is determined by the size and velocity of the money supply. The levels of investing and consumption are determined by the marginal decisions of individual actors.
The IS-LM graph examines the relationship between real output, or GDP, and nominal interest rates. The entire economy is boiled down to just two markets, output and money, and their respective supply and demand characteristics push the economy towards an equilibrium point. This is sometimes referred to as "the Keynesian Cross."
Characteristics of the IS-LM Graph
In the IS-LM graph, the IS curve slopes downward and to the right. This assumes the level of investment and consumption is negatively correlated with the interest rate but positively correlated with gross output. By contrast, the LM curve slopes upward, suggesting the quantity of money demanded is positively correlated with the interest rate and with increases in total spending, or income.
Gross domestic product (GDP), or (Y), is placed on the horizontal axis, increasing as it stretches to the right. The nominal interest rate, or (i or R), makes up the vertical axis. Multiple scenarios or points in time may be represented by adding additional IS and LM curves. In some versions of the graph, curves display limited convexity or concavity.
Limitations of the IS-LM Model
Many economists, including many Keynesians, object to the IS-LM model for its simplistic and unrealistic assumptions about the macroeconomy. In fact, Hicks later admitted model's flaws were fatal, and it was probably best used as "a classroom gadget, to be superseded, later on, by something better." Subsequent revisions have taken place for so-called "new" or "optimized" IS-LM frameworks.
The model is a limited policy tool, as it cannot explain how tax or spending policies should be formulated with any specificity. This significantly limits its functional appeal. It has very little to say about inflation, rational expectations or international markets, although later models do attempt to incorporate these ideas. The model also ignores the formation of capital and labor productivity.